Real Estate Investing for Beginners: The Rate of Return Formula
By Marian Khoury
Calculating the rate of return on rental property is an important step to take in order to assess the viability of your future real estate investment. There are actually a few metrics that you could use to learn of the profitability of your rental property. So in this guide, we will tackle the return on investment and internal rate of return as they are two important rate of return metrics that you should consider. We will break down the rate of return formula for each metric and provide you with the gist of calculating them.
What Is the Return on Investment?
Return on Investment (ROI) calculates the percentage of money that you will be earning after deducting associated costs of owning the rental property. In other words, this basic rate of return formula measures the profit made as a percentage of the cost of the investment.
The rate of return formula for ROI is as follows:
ROI= (Gain on Investment — Cost of Investment)/ (Cost of Investment)
Looking at this formula as a beginner real estate investor, you might think it seems easy to calculate. However, many variables come into play that you need to account for such as financing terms and all the repair/maintenance costs. Let’s take a look at different examples and calculate the return on investment for each.
Calculating Return on Investment for an Investment Financed with All Cash
If you aim to buy a property with cash, calculating the return on investment is fairly straightforward. For example, let’s say you paid $150,000 in cash for your rental property. You then paid $1,000 for closing costs and $9,000 for repairs and collected $1,000 a month. After one year, you earned $12,000 in monthly rent but had $3,600 in costs for water bills, property taxes, and insurance for the year. Your annual return (gain on investment) would then be $12,000 — $3,600 = $8,400.
Now you have all the variables to start plugging into the rate of return formula:
ROI would equal to the annual return after deducting expenses and taxes for that year divided by the total cost of investment:
ROI = $8,400/$160,000 = 5.25%
Calculating Return on Investment for an Investment Financed with a Loan
When you are taking out a loan to pay for your investment property, the rate of return formula becomes a bit more complex. Here’s how you calculate it.
Let’s say you are buying a rental property of the same amount ($150,000) but now you took out a mortgage. You are paying 20% of the purchase price or sale price as a down payment or $30,000, and $3,000 for closing costs. Note that closing costs tend to be higher with a mortgage than if you were to finance the property fully with cash. Finally, remodeling and repair fees amounted to $9,000. So the total out-of-pocket expenses you will have incurred equal to $30,000 as the cash down payment + $3,000 in closing fees + $9,000 in repairs and remodeling fees or $42,000.
Before you start plugging these numbers into the formula, stop there! When you take out a mortgage, there are other ongoing costs associated with the purchase that you ought to account for.
The ongoing costs include:
- The monthly principal and interest payment. Let’s assume here, you took out a 30-year loan with a fixed 4% interest rate. So for the $120,000 borrowed (sales price of $150,000 minus down payment of $30,000), you will be paying $572.9 in monthly repayments.
- Fees of $200/monthly to cover water bills, taxes, and insurance.
Now to find the annual return, one year later, subtract the monthly expenses (mortgage repayments + other fees) for the whole year from the annual rent. So, 12,000–12*(572.9 + 200) = $9,274.8. We can now plug these numbers into the rate of return formula to get the return on investment.
ROI = Annual return / out of pocket expenses = $9,274.8/$42,000 = 0.2208 or 22.08%. This is a pretty high rate of return.
What About the Internal Rate of Return?
Using the internal rate of return as opposed to the return on investment will give you a more exact measurement of the long-term yield of income properties. The internal rate of return is an estimate of the value the property generates during the time frame in which you own it.
To calculate the Internal Rate of Return, you would want to find the Net Present Value (NPV) of an investment. The Net Present Value is the sum of the present value of incoming cash flows minus the outgoing cash flows over a period of time. You can calculate the IRR by setting the NPV equation to zero and solving for r. Here’s the rate of return formula in more detail:
N: The total number of years
Cn: The cash flow in the current period
n: The current period at that step in the rate of return formula
r: The internal rate of return
Solving this rate of return formula by hand can be daunting. It requires trial and error; you need to plug in various numbers for r until you find a value that makes the equation equal zero. Luckily, however, you can insert the rate of return formula into Excel and get your rate in a matter of seconds.
It’s true modern software has made it easier by calculating the IRR for you in just a click. What is more difficult to assess and consider when working with the rate of return formula, however, is determining all the numbers that go into the equation. Moreover, to predict cash flow and payments, you’ll have to make various assumptions about future events relating to the investment, the real estate market, and various factors associated.
Return on Investment vs the Internal Rate of Return Formula
You may be wondering which rate of return formula to use when assessing the profitability of your investment, the return on investment or the internal rate of return? Here are the differences and features of each to help you decide.
- Usage: The internal rate of return formula is used to assess the rate of return of investment especially for a shorter duration of time. The return on investment is used to calculate the performance of an investment over a certain period of time.
- Time Value: The internal rate of return formula is more credible since it takes into account the time value of money. While on the other hand, the ROI does not.
Calculating the rate of return on rental property is not difficult. However, it requires assessing cogently the variables that play into the equation. Moreover, determining which rate of return formula to use depends on your goals for assessing the profitability of your investment. If you are keener on studying the time value of the investment, then consider using the internal rate of return formula. While, if you are keener on learning of the profitability of your investment for a certain period of time, then use the return on investment formula.
Do you still have doubts on how to calculate rate of return on rental property? If you do, visit Mashvisor and explore its real estate rate of return calculator. You can also subscribe to our services and unleash a plethora of tools that will make real estate investing easier and more accurate. To learn about your options for signing up for our services, click here.
Originally published at https://www.mashvisor.com on February 4, 2019.